CLO market cheers end of risk-retention rules

NEW YORK (Reuters) - Wall Street firms are cheering a court ruling that will exempt Collateralized Loan Obligation (CLO) funds from complying with Dodd-Frank Act rules that require investment managers to hold some of their deals’ risk.

The US Court of Appeals for the District of Columbia Circuit ruled last Friday that CLO funds, the largest buyer of leveraged loans, will no longer have to comply with ‘skin in the game’ rules designed to align interests between managers and their investors.

The ruling was a win for the US$501bn asset class and is expected to benefit smaller managers most that struggled to find enough cash to buy the required retention in order to issue new deals or rework existing funds.

“The overall takeaway by many market participants is that this is an important decision that will help grow the market,” said Tom Majewski, founder of Eagle Point Credit Management, which invests in the equity and junior debt of CLOs.

CLO funds performed well during the financial crisis and saw the application of risk-retention rules as unfairly maligning the asset class by lumping them in with similar funds that were blamed for 2008’s meltdown.

The Loan Syndications and Trading Association (LSTA) sued the Federal Reserve (Fed) and Securities and Exchange Commission (SEC) in 2014, arguing the risk-retention rules were “arbitrary, capricious” and “an abuse of discretion.”

The case bounced through the court system, with the Federal District Court for the District of Columbia ruling against the New York-based trade organization in 2016. The LSTA appealed and that decision was overturned by three Court of Appeals judges last week.

Regulators now have 45 days to seek an en banc review, a hearing in front of the active DC Circuit Appeals Court judges. The government also has a 90-day window to seek review from the Supreme Court, according to Richard Klingler, a partner at law firm Sidley Austin and the LSTA’s counsel.

“We are reviewing the court’s decision,” a Fed spokesperson said in an e-mailed statement. An SEC spokesperson declined to comment.

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CLOs, which buy leveraged loans extended to companies including retailer Party City and health care facilities operator HCA, sell different tranches of varying risk of their fund to investors.

Initial concerns that risk retention would limit issuance proved unfounded as CLO volume rose to more than US$117bn in 2017, the second-largest year on record, according to Thomson Reuters LPC Collateral data, after firms put plans in place to comply with the retention rules before the December 2016 effective date.

Attractive yields mean that CLO managers now have a decision to make. Firms issuing deals will still need to comply with the retention rules - at least until the review period is over, said Sean Solis, a partner at law firm Dechert,

With spreads on the most senior Triple A tranches at pre-crisis lows, some CLO managers may still choose to issue now, even if they have to buy risk retention, sources said. Lower spreads on the senior tranches give higher payouts to equity holders who are reimbursed with the interest leftover after every debtholder is paid.

“Yields are too attractive for [the market] to stop taking advantage of issuing new deals and resets,” said Paul St. Lawrence, a partner at law firm Cleary Gottlieb Steen & Hamilton.

Many funds have already warned investors that it is possible that managers may no longer need to hold required retention if the court ruled in the LSTA’s favor, Solis said.

Arrangers need to make investors aware of the ruling and of the possibility that managers may sell their holdings at a future date, said St. Lawrence, which means that the amount that managers were going to buy and retain may change.

Arranging banks may also have to find new buyers for CLO managers’ risk-retention holdings that they no longer intend to keep, sources said.

The future of billions of dollars of risk-retention capital that brought new investors into the asset class is also in question. Many retention vehicles are structured to remain in place even if the rules go away, but some managers may reexamine the funds in light of the ruling, the sources said. But for now, managers may continue to tap that capital.

“If you are about to price a CLO and had a pocket to hold it, a retention pool, you’re still going to use it,” Majewski said.